Americans Living Abroad and the Net Investment Income Tax

Americans
living in
certain
countries may
be able to
avoid the net
investment
income tax,
but it is not
clear at this
point.

A key
point that
must be
decided to
answer these
larger
questions is
whether the
net investment
income tax is
a social
security tax
or an income
tax.

If it is a
social
security tax,
Americans
living in
countries that
have social
security
totalization
agreements
(SSTAs) with
the United
States may be
exempt. If it
is an income
tax, then
taxpayers
would look for
a foreign tax
credit.

There is
no provision
in the
Internal
Revenue Code
for a foreign
tax credit
against this
tax.
Therefore, any
credit would
have to be
based on the
terms of the
income tax
treaty between
the United
States and the
individual’s
country of
residence or
citizenship.
Because none
of these
treaties
currently
address the
net investment
income tax
directly and
no other
authoritative
guidance
exists,
whether these
treaties will
be considered
to allow a
foreign tax
credit for the
net investment
income tax is
an open
question.

Because of
the lack of
guidance on
the issue, a
taxpayer
claiming
exemption
under an SSTA
or credit
under a treaty
should fully
disclose the
position.

The U.S. State
Department estimates
that approximately 7.2
million U.S. citizens
live abroad, plus an
indeterminate number of
green card holders.1
The United States has
social security
totalization agreements
(SSTAs) with 24
countries2
and income tax treaties
with 67.3
The vast majority of
Americans abroad live in
these countries.

When the Sec. 1411
net investment income
tax was passed, little
thought was given to how
it would affect
Americans living abroad,
and with no guidance
issued on the topic, its
effect is unclear. This
article describes how
the net investment
income tax may affect
Americans living
abroad.

If an individual
is subject to the tax,
would a foreign tax
credit (FTC) be
available where the
underlying income that
gives rise to the tax
is:

(a)
Foreign (non-U.S.)
source?

(b)
U.S.-source?

It is
also unclear whether the
tax is a social security
tax for purposes of the
U.S.–Canada SSTA.5

Net Investment
Income Tax in
General

To help
fund 2010’s health care
reform legislation,6
the United States
instituted the net
investment income
tax,7
which is designed to
affect high-income
people. The tax amounts
to 3.8% of a U.S.
person’s net investment
income,8
to the extent the
person’s modified
adjusted gross income is
above:

Roughly,
investment income
includes interest,
dividends, rent,
royalties, and most net
gains. It includes
income from passive
activities.10
It does not include
distributions from
qualified retirement
plans.11

For owners of
controlled foreign
corporations and passive
foreign investment
companies, it does not
include corporate income
that is imputed to the
shareholder (subpart F
and qualified electing
fund income), as they
are not dividends.
Instead, actual
distributions are
subject to the tax.12
It is possible to make
an election to have the
tax apply at the same
time as the subpart F
income is recognized for
ordinary income tax
purposes.13

A U.S. person is a
citizen or resident,
defined in the same
manner as for income
tax.14
The tax does not apply
to nonresident
aliens,15
including those whose
residency is determined
under a result of a tax
treaty.16

The tax went into
effect Jan. 1, 2013, and
is not withheld at the
source, so it is a
material issue for
high-income earners in
this filing season.

Little Guidance to
This Point

The
Joint Committee on
Taxation report did not
address the above
questions about
Americans living
abroad,17
nor did the proposed
regulations.18
In November 2013, the
author had the
opportunity to ask staff
from both the Joint
Committee and Treasury,
and neither was aware of
these questions having
been raised in the
course of drafting the
law or regulations.
After the author’s
discussion with Treasury
(including providing a
draft of this article),
Treasury did address the
second question
regarding an FTC, in the
preamble to the final
regulations issued Dec.
2, 2013. However, it did
so in the broadest
terms, saying only that
the regulations were not
an appropriate venue for
such answers.19

The author could find
no discussion of these
questions in the
academic literature, but
some commentators from
large accounting firms
have suggested in their
public materials that no
protection from this tax
is available.20
There simply is no
meaningful guidance in
this area.

To
address the question of
whether Americans living
abroad are subject to
it, one must determine
which type of tax the
net investment income
tax is. Is it a social
security tax or an
income tax?

Is
the Net Investment
Income Tax a Social
Security Tax?

For an individual who
lives in Canada (as an
example), the
U.S.–Canada SSTA governs
coverage under Social
Security and Medicare,
as well as the Canadian
equivalent, the Canada
Pension Plan (CPP).
Individuals employed
primarily in Canada and
self-employed
individuals who reside
in Canada are subject to
the provisions of the
CPP, not U.S. Social
Security.21
Consequently, if the net
investment income tax is
a social security tax,
then an individual who
lives in Canada and is
subject to the CPP would
be exempt from it.

But is the net
investment income tax a
social security tax?
Under the SSTA, the
covered taxes are listed
as those imposed by
Internal Revenue Code
chapters 2
(self-employment tax)
and 21 (Federal
Insurance Contributions
Act (FICA) tax).22
The net investment
income tax is contained
in a new chapter (2A) of
the Code, which is not
specifically covered by
the SSTA. However, the
SSTA anticipates this
possibility:

[T]his
Agreement shall also
apply to laws which
amend, supplement,
consolidate or supersede
the laws specified in
paragraph (1).23

Most U.S.
SSTAs Have Similar
Provisions

The net
investment income tax is
designed to pay for an
expanded Medicare. In
the statute, it is
called a “Medicare
contribution.”24
The Joint Committee
report addresses the tax
in a Social
Security/Medicare
context, not an income
tax context.25

The tax was imposed
in parallel with an
increased Medicare tax,
a 0.9% surtax on wages
and self-employment
income in excess of
thresholds identical to
those applying to the
net investment income
tax.26
The objective of the net
investment income tax
was to ensure that
individuals with
similarly high income
levels who derive income
from nonwage sources
contribute to the newly
expanded health care
program in a similar
manner.

It is
noteworthy that the
additional Medicare
taxes on wages and
self-employment income
are specifically
identified as ones to be
covered by SSTAs. No
similar guidance was
provided for the net
investment income tax.
Whether this means that
the tax was intended to
be covered is anybody’s
guess.

However, the
author’s inquiries to
the Joint Committee and
Treasury indicate that
the question was simply
never addressed.
Furthermore, although
Treasury addressed the
FTC question when it
issued final regulations
(see below), it did not
consider the SSTA
issue.

The fact
that there is no FTC
mechanism in the tax
also suggests that the
tax is designed to be a
Medicare tax rather than
an income tax. However,
there is no specific
requirement that funds
from this tax be
directed toward
Medicare. Receipts
simply go into general
revenues.27

A major purpose of
this tax is to help
finance health care
subsidies under the Sec.
5000A individual mandate
to maintain minimum
essential coverage.
American residents
abroad are not subject
to the mandate.28
Additionally, they
rarely access Medicare
coverage.

It is
unclear whether the net
investment income tax is
covered by the SSTA on
the basis that it amends
or supplements chapters
2 and 21 of the
Code.

Individuals
Who Are Neither Employed
nor Self-Employed

SSTAs are designed
according to the idea
that individuals
receive coverage
through their work
status. However, some
people are neither
employed nor
self-employed. Into
this category fall
retirees, parents who
do not work outside
the home, and
children.
Independently wealthy
individuals and those
with interests in
closely held
corporations who are
remunerated primarily
through interest and
dividends would also
fall into this
category.

To this point,
social security
coverage relating to
this latter category
has not been relevant.
The net investment
income tax, however,
makes the issue
germane. One could
argue that in this
case, where an
individual has no
foreign (non-U.S.)
social security
coverage, the SSTA has
no effect, and the
individual would then
be subject to U.S. laws.29

On the other hand,
some individuals over
the retirement age are
exempt from
contributions to the
foreign social
security program. Such
individuals may have
employment or
self-employment
income, but they are
still treated by the
Social Security
Administration as
exempt from FICA taxes.30 Again, because
the SSTA is designed
according to the idea
that coverage is a
function of providing
services, it is inadequate to answer
the question
definitively.

Or Is It an Income
Tax?

When a U.S.
citizen resides abroad,
he or she is still
subject to U.S. tax on
worldwide income. Most
foreign countries tax
their own residents on
their worldwide incomes,
and even those that do
not do so still tax them
on local-source income.
So Americans living
abroad are almost always
subject to tax under at
least two systems.

Double taxation is
universally recognized
to be a bad thing. It
interferes with
international business
and individual mobility
and is fundamentally
unfair. Consequently,
U.S. law and treaties
include FTC mechanisms
to mitigate this
problem. If the net
investment income tax is
an income tax, then the
question arises whether
an FTC is available in
respect of foreign tax
paid.

Even with the
net investment income
tax, foreign-country
income taxes where most
Americans reside are
typically higher than
U.S. taxes. In most
Organisation for
Economic Co-operation
and Development nations,
top marginal tax rates
range from 40% to 50%,
with some (like France)
much higher. U.S.
brackets are generally
wider, and the United
States offers itemized
deductions (e.g.,
mortgage interest and
property taxes) that
typically lower the
income tax base
materially compared with
that of other nations.
Thus, for most of the
individuals described
here, an FTC mechanism
would effectively
obviate the impact of
the tax.

Where
the Income Giving Rise
to the Tax Is Not
U.S.-Source

For
Americans living abroad,
the foreign country, as
a general rule, has the
first right of taxation
with respect to income
that is not U.S.-source.
The normal mechanism to
avoid double taxation is
an FTC.

U.S.
Foreign Tax Credit

There is no provision
in the Internal Revenue
Code or the regulations
for an FTC against the
net investment income
tax. The domestic-rule
FTC applies only to
reduce regular income
tax, not the net
investment income
tax.31
Form 8960, Net
Investment Income
Tax—Individuals,
Estates, and
Trusts, for
calculating net
investment income tax
contains no FTC
calculation.

Treaty
Foreign Tax Credit

Treaties often ensure
that there is a
supplementary FTC
mechanism to mitigate
double taxation. For a
U.S. citizen resident in
Canada, for example, the
treaty32
allows an FTC for
Canadian tax in
computing United States
tax:

[D]ouble
taxation shall be
avoided as follows: In
accordance with the
provisions and subject
to the limitations of
the law of the United
States (as it may be
amended from time to
time without changing
the general principle
hereof), the United
States shall allow to a
citizen or resident of
the United States . . .
as a credit against the
United States tax on
income the appropriate
amount of income tax
paid or accrued to
Canada.33

“United States tax”
means the taxes referred
to in Article II of the
treaty, other than,
inter
alia, Social
Security taxes.34

The fact that the tax
arises in a separate
section of the Internal
Revenue Code is not
relevant to this
determination:

This
Convention shall apply
to taxes on income . . .
irrespective of the
manner in which they are
levied. . . .35
The Convention shall
apply also to any taxes
identical or
substantially similar to
those taxes to which the
Convention applies under
[the above paragraph] .
. . which are imposed
after March 17, 1995, in
addition to, or in place
of, the taxes to which
the Convention applies
under [the same
paragraph].36

Of course, the words
“subject to the
limitations of the law
of the United States”
could be interpreted to
mean that there is no
FTC, because there is no
provision for one in the
domestic law. The IRS
commented in the
preamble to the final
regulations under Sec.
1411 that where such
words are included, a
treaty-based foreign tax
credit would not be
allowed.37

Canada’s
Foreign Tax Credit

Canada taxes
non-U.S.-source income
without regard to U.S.
taxation and has no
domestic mechanism to
offer an FTC in respect
of the net investment
income tax. To qualify
for Canada’s foreign tax
credit, the qualifying
income must have a
source in one or more
countries other than
Canada.38
Canada calculates FTCs
separately by
country.39
The net investment
income tax is deemed not
to be creditable,
because it is payable
solely by virtue of U.S.
citizenship (noting that
the tax does not apply
to nonresident
aliens).40
Under the treaty, Canada
is not obliged to offer
a credit. The credit
required under the
treaty is limited to the
amount that would apply
if the individual were
not a U.S. citizen.41

Treaty
Override

In the
United States (unlike
Canada and most other
countries), a treaty
does not automatically
supersede domestic
law.42
Instead, “[t]he
provisions of [the Code]
shall be applied to any
taxpayer with due regard
to any treaty obligation
of the United States
which applies to such
taxpayer.”43
“For purposes of
determining the
relationship between a
provision of a treaty
and any law of the
United States affecting
revenue, neither the
treaty nor the law shall
have preferential
status.”44
These statements are of
little help.

The
courts have determined
that, as a general rule,
the provision that came
later in time
prevails.45
Double taxation can
result from the
application of this
rule. One example of
this phenomenon was the
arbitrary limitation of
the alternative minimum
tax (AMT) FTC to 90% of
the AMT otherwise
payable, even in cases
where the foreign-source
income was greater than
90% of all income.46
However, one of the
critical elements in
this case was that
legislators had
indicated they were
conscious of the treaty
override. With the net
investment income tax,
this intent is not
evident from the
legislation or the
committee reports. As
noted, in the rush to
finalize legislation,
the question was simply
not addressed. How does
one address an implicit
treaty override when
there is no expression
of that intent? This is
a critical factor that
distinguishes this tax
from the AMT FTC
limitation.

The
IRS, by noting in the
preamble to the
regulations that a
treaty credit may be
allowed and that
residency determined
under a treaty will be
respected,47
implicitly acknowledged
that this new tax is not
intended to be a treaty
override.

The
author suggests that in
light of the wording of
the U.S.–Canada treaty,
especially Article II
anticipating the
enactment of additional
taxes, an FTC should be
allowed, notwithstanding
Treasury’s comments.

Where the Income
Giving Rise to the Tax
Is U.S.-Source

As with most
countries, Canada
ordinarily provides an
FTC for U.S. tax
properly levied against
U.S.-source income.48
This provision is
reinforced by the
treaty.49
This is true even where
the tax is a social
security tax.50

However, Canada is
not required to provide
an FTC for U.S. tax in
excess of that properly
allowed under the
treaty. Where the treaty
limits the U.S. tax to
an amount lower than the
ordinary U.S. statutory
rate, that treaty limit
forms an upper bound on
the creditable tax.51

Furthermore, if a
U.S. citizen is taxable
but a nonresident alien
would not be on the same
type of income, Canada
is not required to
provide an FTC.52
As noted above, a U.S.
nonresident alien is
exempt from this tax.
Consequently, Canada
would not offer an FTC
in respect of the net
investment income
tax.

Where the
statutory calculation
results in higher tax
than the treaty allows,
the United States is
required under the
treaty to offer a
special tax credit to
reduce its own tax to
the treaty level.53

Provided the Canadian
tax is sufficient, this
credit should offset the
net investment income
tax. Given that Canadian
effective tax rates for
high-income earners are
typically considerably
higher than U.S. rates,
this should be the case
almost universally.

Conclusions

For an individual
living in a country with
an SSTA, if the net
investment income tax is
a social security tax,
it should be excluded
from applicability
because:

The net investment
income tax supplements
existing Social
Security taxes;

It is designed to
fund an expanded
Medicare;

Americans abroad
are exempt from the
Patient Protection and
Affordable Care Act’s
individual mandate,
and this tax is
designed to fund
subsidies for that
mandate;

It is described as
a Medicare tax in the
legislative text;

Its
location in the Code
is consistent with
that status;

The tax mechanism
dovetails with the
increased ordinary
Medicare taxes on
earned income; and

The
absence of an FTC
mechanism is
consistent with a
social security tax,
not an income tax.

This
position is not without
risk:

SSTAs do not
explicitly cover the
tax;

An
individual who is not
covered by foreign
social security (by
reason of not earning
income from employment
or self-employment)
may be excluded from
the SSTA; and

Funds are not
earmarked directly for
Medicare.

If the net investment
income tax is not a
social security tax,
there is a good argument
that an FTC should be
allowed under a treaty.
This is true whether the
income in question is
U.S.-source or not:

It is hard to
argue that the tax is
neither a social
security tax nor an
income tax; and

There is no
express limitation in
U.S. law on the use of
an FTC under a treaty.

Again,
this position is not
without risk. The Code
has no provision for an
FTC in respect of this
tax. That omission may
be sufficient to deny
the treaty credit. The
result would be
unforeseen double
taxation.

An
overwhelming majority of
Americans abroad live in
countries with SSTAs
and/or tax treaties. In
most or all of these
countries, the tax
treaty FTC mechanism
applicable to U.S.
citizens is similar to
that in the Canadian
treaty, so similar
conclusions would likely
apply.

How to File
Returns

Of course,
it is quite possible
that the IRS would view
either approach as
incorrect (that the tax
is covered by the SSTA
or that there is a
treaty-based FTC
available in a specific
jurisdiction).

Taking such a
position would not be
for the faint of heart.
Because such a position
would be contrary to the
design of the IRS form
and Treasury has not
indicated support for
broad-ranging treaty
FTCs, it would be
important, at the very
least, to make proper
disclosure to mitigate
the likelihood of
imposition of
preparer54
and taxpayer55
penalties.

For an
SSTA exemption, safe tax
practice would suggest
that filing Form 8275,
Disclosure
Statement, is a
good idea. For a treaty
position, it might still
be advisable. There is
little downside with
such an approach. The
presence of Form 8833,
Treaty-Based
Return Position
Disclosure Under
Section 6114 or
7701(b), and
absence of Form 8960,
combined with a high
income, will alert the
IRS to the issue even in
the absence of Form
8275. These positions
are not likely to “slide
through.”

Because
of the sparse IRS
guidance, the fact that
no court has pronounced
on the issue, and that
there has been no
meaningful discussion in
the literature, it would
be very difficult to
argue that a taxpayer
has substantial
authority56
for either position.
However, the author
submits that there is a
reasonable basis57
for either position, on
the basis of the
arguments discussed
above.

Editor’s
note:A version of
this article was
published in Canada in
the International
Tax
newsletter.

4All references to
“individuals” henceforth
are to U.S. citizens
living abroad, except as
specifically noted.
Because of the large
number of such people in
Canada, and the author’s
familiarity with the
country, the Canadian
situation is used as
illustrative.

17Joint Committee
on Taxation, Technical
Explanation of the
Revenue Provisions of
the “Reconciliation
Act of 2010,” as
Amended, in
Combination With the
“Patient Protection
and Affordable Care
Act” (JCX-18-10)
(March 21, 2010).

24The full name is
“Unearned Income
Medicare Contribution”
(Health Care and
Education Reconciliation
Act of 2010,
§1402(a)(1)).

25Joint
Committee on Taxation,
Technical
Explanation of the
Revenue Provisions of
the “Reconciliation
Act of 2010,” as
Amended, in
Combination With the
“Patient Protection
and Affordable Care
Act” (JCX-18-10)
(March 21, 2010), at
134.

Kevyn
Nightingale is a
partner with MNP
LLP in Toronto.
He sits on the
joint
international
tax committee
of the AICPA and
CPA Canada. For
more information
about this
article, contact
Mr. Nightingale
at kevyn.nightingale@mnp.ca

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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